Discover Financial (DFS), a recent spin-off from Morgan Stanley, is a credit card issuer that also operates the fourth largest credit card network in the US. DFS also owns Pulse, the third largest debit network, which it acquired in 2005. The company has historically operated a “closed loop network”; it acquired all of its merchants directly and was the sole issuer of the Discover Card. Recently, however, DFS has started outsourcing part of the merchant acquiring function and has signed up third-party issuers to issue credit cards on the Discover network (more on this later). Most sell-side analysis of DFS simply applies a “lending” multiple to the company’s total earnings. This implies a large negative value to the international operations (currently losing money), ascribes zero value to Pulse and ignores the potential benefit from third-party merchant acquiring and issuing.

 

The base value of DFS resides in its core domestic credit card business. DFS currently has $47bn of total U.S. credit card receivables and the Discover Network processes over $100bn of annual sales volume. $20bn of the company’s receivables is funded on-balance sheet mostly through brokered deposits from the company’s wholly owned Discover Bank. The remaining $27bn is funded through securitization. The U.S. card business generates roughly $1.90 (shown below) in earnings per share growing at least 4% per year (low end of company guidance for receivables growth, no operating leverage). At 12x trailing earnings the U.S. card business would be worth ~$23 or 18% above the current stock price.

 

 

 

This $23 price represents just a 13% premium to U.S. receivables. BofA paid a 23% premium for MBNA and WaMu paid a 17% premium for Providian. Every credit card portfolio is different of course, but this gives you some idea of past transaction values.

 

Many analysts have pointed out that as a result of the change in the bankruptcy laws in 2005, net charge-offs for the credit card industry have been below historic averages, hitting roughly 4% in the latest quarter (management expects long term charge-off rates to average closer to 5%). This, they argue, means recently reported earnings are artificially inflated. While it is true that the level of net charge-offs in the past 2 years have been below norms, it isn’t right to assume that further net charge-off increases will eat into the company’s profitability. A higher charge-off environment results in higher fees – late fees and over-limit fees both increase significantly. Also, revolving balances tend to increase. Additionally, DFS retains some pricing power – they can re-price accounts (increase interest rates, fees), with written notification to cardholder. Unless cardholder proactively cancels his card, rate increase automatically kicks in. Company claims to have some “dry powder” in pricing. Looking historically, (based on information from management and data from the Federal Reserve Bank of Philadelphia) as charge-offs rise these counterbalancing factors have been sufficient to maintain profitability.

 

Another concern with DFS (especially during the credit market turmoil of late) is access to funding. DFS has demonstrated an ability to very quickly raise large sums of money through their brokered deposit strategy. For example, they were able to generate $3bn of deposits in the third quarter, resulting in a total cash balance of $8.6bn as of August 31, 2007. DFS also maintains a $2.5bn credit facility and $2.4bn in committed conduit capacity from a consortium of banks. Additionally, since they restructured their securitization trust (moving from a linked to a de-linked structure) the company now has $5bn of AAA issuance capacity as they were recently able to sell the BBB tranche. In total, the company has close to ~$17bn of liquidity which is more than ample as their securitization funding has an average duration of 2.3 years.

 

DFS has several other opportunities to grow the business and/or increase profitability.

 

1. Merchant acquiring strategy – DFS has recently decided to outsource a portion of the merchant acquiring function. As a result, sometime towards the end of 2008 DFS will be on parity with MasterCard and VISA in terms of merchant acceptance. DFS has already signed contracts with the largest merchant acquirers, all that remains is to finish systems integration (Global Payments just announced that DFS has been fully integrated into all of its direct merchants). This change in strategy does not entail a net cost for DFS as their internal merchant acquiring costs are relatively high. Though they will have to give up some economics to the 3^rd party acquirers, the net impact is neutral as they save on significant internal merchant acquiring costs. Quantification of the merchant acquiring benefit is very difficult. What we do know is that currently DFS is only ~5% of US credit card spend and there is certainly room for them to take more share. The average spend on a Discover Card is ~$500 below the MC/VISA average. DFS’s most loyal customers (those who use Discover Card as their first preference) will see immediate increased spend with greater merchant acceptance – currently they must resort to a back-up Visa/MC at many locations. Also, for those customers for whom Discover is NOT the first choice, the number one reason given is inferior merchant acceptance. Lastly, DFS’s active accounts stood at ~40%, well below average for the industry, As merchant acceptance increases company should be more successful in increasing % active accounts.

 

2. Third Party issuing – DFS has struck agreements with a handful of banks and finance companies (HSBC and GE Money for example) to issue Discover cards. As third party issuance increases, the incremental spend generates high profit network fees for DFS as the network costs are largely fixed (this is akin to the MasterCard business). Though the economics for third party Discover Card issuers are currently not as attractive as for third party Amex (DFS discount rate with merchants is lower than Amex), issuers still have a desire to issue Discover Cards as it allows them to diversify away from VISA/MC and offer their customers something “new”.

 

3. Leveraging the value of the network – DFS owns the fourth largest credit card network in the country. The network has taken over 20 years to build – and from a replacement standpoint is nearly impossible to replicate. It is unlikely that anyone will ever successfully start another credit card network in the U.S. While the current profitability of the network is unclear, my impression is that it is losing money or break-even. The company is attempting to drive incremental value from the network through its third party issuance strategy described above. However, at its current profitability the network would likely be worth more in the hands of someone else. Companies that might generate value from the network are large credit card issuers like Banc of America (which has claimed no interest in acquiring DFS) or foreign players like JCB or China UnionPay who might be interested in developing a U.S. network presence.

 

4. Pulse – DFS acquired Pulse in January 2005 for ~$300mm. Pulse network volume is growing 20+%. Pulse could be worth $1- $2 per DFS share.

 

5. International operations – the international business, which consists of a Discover branded VISA/MC issuer in the UK, has $4.6bn of managed receivables. The international business lost ~$220mm in the last 12 months as a result of abnormally high bankruptcies and credit losses in the UK. Because the business is more tightly regulated DFS has not been able to offset these higher credit losses with fees and rate. The future of this operation is unclear – DFS has stated that they will give this business at least another year to turnaround. These operations could be worth $0 - $1 per DFS share.

 

6. MasterCard/VISA DOJ litigation – In 2004 the U.S. DOJ prevailed in its antitrust lawsuit against Visa/MC. Discover, together with American Express, is pursuing a lawsuit against MC/VISA for their historical anti-competitive practices. Morgan Stanley is entitled to the first $700mm of any damages awarded DFS (per the separation agreement) as well as 50% of any amount over $1.5bn. It’s not clear when the final award will be determined or how it will be split between DFS and AMEX, but the ultimate award (after MS’s portion) to DFS could be anywhere in the range of $0 - $2 per share after tax.

 

According to management the company is “well capitalized” and should continue to generate excess capital going forward. Management has guided to a 17-18% ROE and receivables growth of only 4-8%, leaving 9-14% of equity (anywhere from $1.00 to $1.50 per share) in excess capital. DFS will distribute a large portion of this capital through a combination of dividends and buybacks.

 

Combining the base U.S. Card business with the opportunities outlined above implies a total value for DFS of at least $25 per share. With potential increased profits from the 3rd party merchant acquiring strategy, increased profits from the 3rd party issuance business, potential sale of the network, or sale of Discover overall, the value could be as high as $35+ per share.